The experience of many Latin American countries suggests that industrial groups have resisted “Dutch disease” by demanding government intervention to protect their industries, rather than passively accepting a reduction in their relative importance in the economy.

The rise in commodity prices between 2004 and 2007 increased the value of Latin American exports and improved the balance of payments. This caused real exchange rates to appreciate, enabling most Latin American economies to reduce their external indebtedness substantially.

RGMs in Latin America: external debt

Source : Oxford Economics

By the time the 2008-09 crisis hit, most countries in the region had reduced external debt and held large capital buffers in the form of foreign reserves.

Therefore, they could fund counter-cyclical macroeconomic policies to offset slower growth without compromising financial and macroeconomic stability. This explains much of their relatively resilient economic performance since 2009.

Challenges

Reliance on commodities can, however, bring problems even when prices are booming.

High prices encourage domestic resources to be channeled into fast-growing commodity-related sectors, to the detriment of other manufacturing activities. Exchange rate appreciation makes the domestic industrial sector even less competitive, causing it to be crowded out by cheaper imported goods. This phenomenon has become known as “Dutch disease”.

Commodities prices are subject to large cyclical swings over time and over-reliance on commodities can, therefore, be detrimental to growth prospects.

Commodity prices tend to respond more aggressively than manufacturing prices to fluctuations in the business cycle. Thus, commodity-based economies are prone to large swings in capital flows and exchange rates, discouraging investment.

To avoid fiscal crises, resource-rich countries must develop policies to protect their economies.

For example, in Brazil, the government raised import tariffs on cars produced outside the Mercosur free trade area. Mexico awarded tax breaks for domestically-produced consumer durables.

Government protection of industries must be handled carefully to avoid holding back the economy by distorting the advantages of different channels of growth.

Real non-fuel commodity prices

Source : Oxford Economics, IMF and Haver Analytics

Opportunities

Some of these problems can also be mitigated by appropriate resource management.

Sovereign wealth funds enable governments to invest a substantial portion of commodity export revenues in foreign assets. This allows them to protect fiscal revenues from political pressure, corruption and waste.

Diversification into overseas assets may also help to contain currency appreciation. The returns from these investments can support fiscal spending or be used to manage exchange rate volatility.

Ultimately, such funds allow countries to adopt counter-cyclical policies to avoid both the excesses of prosperity in boom times and the depths of depression when prices collapse.

Further development of infrastructure, education and R&D may also help to support emerging industries and facilitate competition in global markets.

If implemented successfully, policies such as these should help the RGMs to diversify their economies and reduce the risk of over-reliance on commodities.

By following this path, the huge endowment of natural resources in Latin America should prove to be a blessing rather than a curse.

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